Strategic Reward Systems

HR Management

Mahesh
Strategic Reward Systems :
Pay for Performance

Reward Systems consist of the following

elements:
Financial Rewards – Compensation
1. Base Salary
2. Pay Incentives
3. Employee Benefits
Non-financial Rewards
1. Intrinsic Rewards – centers on the work itself
2. Praise, recognition, time off and other rewards
given to the employee by peers or superiors.
Mahesh
Strategic Reward Systems :
Pay for Performance

Reward Systems in most cases should be

consistent with other HR systems.
The Reward System is a key driver of:
 HR Strategy

 Business Strategy

 Organization Culture

Mahesh
Strategic Reward Systems :
Need for Consistency with Other HR Systems
Skill-based pay

Training Culture
Overtime
pay rules in
Merit pay reinforces
contract
performance culture
Labor Rewards
Relation
s Performance
Management

Sign-on Bonus
Employment
Merit Pay

Mahesh
Strategic Reward Systems

Critical Thinking Question:

1. Should pay policies “lead” or “lag” the
development of other HR systems?

Mahesh
Theoretical Models of Pay and Performance:
Equity theory (Adams, 1963)

Assumptions:
 People develop beliefs about what is a fair reward
for one’s job contribution - an exchange
 People compare their exchanges with their
employer to exchanges with others-insiders and
outsiders called referents
 If an employee believes his treatment is inequitable,
compared to others, he or she will be motivated to
do something about it -- that is, seek justice.

Mahesh
Theoretical Models of Pay and Performance:
Equity theory (Adams, 1963)

Is/Os versus Ir/Or

 O = Outcomes: the type and amount of
rewards received
 I = Inputs: employee’s contribution to
employer
 R = Referent: comparison person
 S = Subject: the employee who is judging
the fairness of the exchange

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Equity Theory – Exchange Scenarios

 Case 1: Equity -- pay allocation is perceived to

be to be fair - motivation is sustained
 Case 2: Inequity (Underpayment) -- Employee
is motivated to seek justice. Work motivation is
disrupted.
 Case 3: Inequity (Overpayment) -- Could be
problem. Inefficient. In other cultures
employees lose face.

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Consequences of Inequity

 The employee is motivated to have an equitable

exchange with the employer.
 To reduce inequity, employee may…
 Reduce inputs (reduce effort)
 Try to influence manager to increase outcomes
(complain, file grievance, etc.)
 Try to influence co-workers’ inputs (criticize others
outcomes or inputs)
 Withdraw emotionally - or physically (engage in
absenteeism, tardiness, or quit)

Mahesh
Equity Theory Implications

 There is tension between internal and external pay

equity: Decide where to place the emphasis.
Example: “In and out” versus “lifelong” employment
system
 Let employees know who their pay referents are in the
pay system: identify pay competitors and internal pay
comparators.
 Strive for consistent pay allocations
 Monitor internal pay structure and position in the labor
market for consistency.

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Agency Theory

 Agency theory is a theory of governance in the

workplace.
 It tries to solve the problem of separation of
ownership (atomistic shareholders) and control
(professional executives and non-owners)
 It also tries to solve conflicts of interest between
managers and employees with delegated
responsibilities.

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Agency Theory

1. Principals = owners or managers who delegate

responsibilities
2. Agents = managers or employees who manage
firm assets for owners or other principals.
3. Information asymmetry = managers or other
agents have greater access to strategic
information than principals, who are not willing
to bear the cost of directly monitoring the
agents due to steep agency costs.

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Agency Theory

4. Risk Preferences – principals are risk neutral

and willing to bear greater risks than agents
because their asset wealth is more likely to be
diversified between corporate assets and other
equities/investments. Agents are more risk
averse than principals, because most of their
wealth is concentrated in the firm and received
in the form of pay and opportunities for
promotion.

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Agency Theory

5. Moral Hazard – agent is tempted (and some

cases succeeds) in taking advantage of
information asymmetry with principal and act
opportunistically (defined as making decisions
not aligned with principal’s interests) and use
the firm resources to maximize wealth of the
agent (often at the expense of the principal).

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Agency Theory

6. Agency Contract – provides solution to moral

hazard/agency problem, by establishing “rules
of the game” to control agent opportunism –
agent’s performance will be judged by
outcomes (often financial benchmarks) not
behaviors (which require direct supervision of
agent’s actions). These outcomes will reflect
principal’s goals and risk preferences.

Mahesh
Agency Theory

7. Incentive alignment – the agency contract will

specify a compensation plan that aligns the
interests of the principal and agent. This agency
contract will be a type of pay for performance plan.
Meeting or exceeding pre-agreed upon financial or
non-financial outcomes triggers various forms of
compensation (individual or group-based) for the
agent. Some agency costs are borne by the
principal in the form of financial incentives for the
agent.

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Tournament Theory

1. Tournaments are competitions between peers to

achieve a promotion to a higher rank along with the
pay and perks that go with it.
2. Tournaments are likely to result in a “winner take all”
outcome.
3. Managers who enter the tournament must forego
other alternatives (such as jobs with other firms, start
own business, receive more pay with an alternative
opportunity) to compete in the tournament.

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Tournament Theory

4. A high pay differential (such as the CEO

receiving much greater pay than any
subordinates) attracts more “players” to the
tournament.
5. Players must “invest” (work long hours, accept
less pay, show loyalty to their boss) to enter the
tournament – firm captures value from these
players, more than what it gives up to the
“winner” for the prize.

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Controversies that Surround Pay for
Performance Plans

1. Single Mindedness – “you get what you pay

for” – no more, no less. The activities that are
rewarded get done, to the exclusion of other
activities that are not rewarded. Example: The
dysfunctional behaviors that are observed when
a sales representative is put on straight
commission.

Mahesh
Controversies that Surround Pay for
Performance Plans

2. Control – externalities can control the

outcomes, positive or negative. There can be
windfall affects (the bull market improving the
stock value of all stock options) or negative
externalities (a bear market or recession that
lowers the value of all stocks). Employee
performance results may be magnified or
diluted by these effects.

Mahesh
Controversies that Surround Pay for
Performance Plans

3. Measurement error – some measures can be

“gamed” or manipulated and may not reflect
“true” performance. Sales reps can withhold
sales and report it in a different period so they
are not penalized by a cap on sales
commissions. Managers can use “creative
accounting” measures to report greater profits
than were actually experienced by the firm.

Mahesh
Controversies that Surround Pay for
Performance Plans

4. Inflexibility – managers or employees may

resist change of the basis of compensation
because they are comfortable with current
basis for pay and want to avoid risk of taking
reduction in earnings in new system.

Mahesh
Controversies that Surround Pay for
Performance Plans

5. Misalignment of incentives – if pay emphasis is on a

goal that is no longer relevant, that goal will continue
to be emphasized until the pay system places
emphasis on a different objective.
For example, managers may emphasize short-term
goals, even if long-term goals are more relevant, until
the pay system recognizes long-term goals to a
greater extent than short-term goals. The reward mix
for complex jobs with several goals must reflect the
relative value of attaining the mix of goals.

Mahesh
Controversies that Surround Pay for
Performance Plans

6. Line of Sight problem - division performance and

corporate performance should be reflected in the
pay system. If division performance and corporate
performance are closely linked than both division
and corporate performance should contribute
incentives to the managers’ pay for performance
plan. If division performance is independent of
corporate performance, then the emphasis should
be on rewards for meeting division goals.

Mahesh
Some Suggestions for More Effective Pay For
Performance Plans

Pay and Performance should be Loosely

Coupled – this gives managers more flexibility
to make changes when new situations arise.
Example: a formula with a bonus based on a
moving average of a 3-year historical
performance period. A 3-year period smoothes
out performance over a longer cycle.

Mahesh
Some Suggestions for More Effective Pay For
Performance Plans

It is Necessary to Nurture the Belief that

Performance Makes a Difference – there are
important cultural values that are supported with
pay for performance even if the accuracy of the
performance metrics and the fairness of the pay
allocations fall short of an ideal situation.
Abandoning pay for performance may be more
problematic than having an imperfect pay
system.

Mahesh
Some Suggestions for More Effective Pay For
Performance Plans

Pay for Performance systems should be

designed to fit each firm’s unique situation –
imitation of other firm’s plans should be avoided

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Six Myths about Pay (Pfeffer, 1998)

1. Labor rates and labor costs are the same thing.

2. Labor costs can be reduced by lowering labor rates.
3. Labor costs are a significant portion of total costs.
4. Low labor costs are a potent source of competitive
advantage.
5. The most effective way to work productively is
through individual incentive compensation.
6. People work primarily for money.

Mahesh